A Steadier Course For China ETFs

China is the largest country weight in the widely followed MSCI Emerging Markets Index and the world's second-largest economy is playing a pivotal role in the upside being delivered by developing world equities. For example, the iShares China Large-Cap ETF (NYSE:FXI), the largest China exchange traded fund listed in New York, is up nearly 15 percent year-to-date.

During the go-go years of the emerging markets boom, investors became accustomed to staggering economic growth rates in China, meaning anything less than jaw-dropping could be seen as disappointing and illicit calls for a hard landing. Fortunately, that isn't the case this year.

Moderate Slowdown

Chinas economic growth is slowing down slightly after an unexpectedly strong first quarterShould you worry about a hard landing? said BlackRock in a recent note. At least not for the time being, we think. A moderate slowdown from the surprise 7% growth rate of the last quarter is in fact welcome, in our view, as the country rebalances its economy and downshifts to a more sustainable pace of growth that is less reliant on credit.

The iShares MSCI China ETF (NYSE:MCHI) underscores the point that many market participants aren't fretting a hard landing in China. That ETF is up nearly 25 percent year-to-date, well ahead of the just over 18 percent returned by the MSCI Emerging Markets Index.

Breaking It Down

Home to $2.4 billion in assets under management, MCHI is undoubtedly a large China ETF. More importantly, MCHI is large in terms of number of holdings with 152, or about triple the number found in FXI. MCHI is also a tech-heavy ETF with that sector accounting for more than 36 percent of the fund's weight. Chinese Internet titans Tencent Holdings and Alibaba Group Holdings Ltd (NYSE:BABA) combine for over 27 percent of MCHI's weight, explaining in large part the ETF's out-performance this year.

China is working to reduce leverage at its financial institutions, a theme that could affect a slew of China ETFs as many of these funds have significant exposure to financial services stocks. The sector is the largest weight in FXI and the second-largest in MCHI.

A crackdown on financial leverage could limit spending by state-owned enterprises in the second half of the year, but we see it as unlikely to hurt private sector lending, said BlackRock. Policy tightening has mainly targeted the shadow financial sector, smaller banks and non-bank lenders, which hold debt more than twice the economys size. We see policymakers treading carefully to prevent accidental seizures in this system, but there are risks of overtightening in a highly leveraged economy. The longer Chinas debt problems are not addressed, the more the risks grow.